The Outlook: July
2018 economic commentary

Colin Warren, chief economist at AFH Wealth Management, weighs in on market moves and investment challenges.

A warning from the US yield curve?

Investors are starting to worry about recent developments in the US yield curve, but its signalling power might be distorted.

Wouldn’t it be great if there were an indicator that gave you advance warning of a pending recession? The onset of recession generally spells bad news for risk assets, so if you knew a downturn was coming, a portfolio could be adjusted accordingly. As a result, it is not surprising that economists study a range of economic and financial data for early signs that the economy is transitioning from one phase to another. One often cited indicator that has proved useful in the past is the so-called US treasury yield curve.

What is a yield curve?

A yield curve is a graph that plots the yield, or annualised interest rate, of a fixed interest security against the time to maturity of that security. Yield curves are normally upward sloping, that is to say that an investor would demand a higher yield for investing their money for, say, 10 years than two years. As can be seen in the chart, which shows the yield curve prevailing at the beginning of 2017 and that as of mid-July, the curve has flattened considerably over the last 18 months, as the gap between 2-year and 10-year yields has narrowed.

US Treasury Yield Curve

It is this gap between longer maturity and shorter maturity US treasury securities that has provided useful information regarding future economic trends. The chart below from the Federal Reserve Bank of St. Louis shows the gap between the 10-year US treasury yield and that of the 2-year yield over time. As can be seen, during periods when the gap turns negative, i.e. when the yield curve inverts or becomes downward sloping, a recession - as indicated by the shaded periods - has followed.

US yield curve and recessions

Why might this be the case? Yield curve inversions usually take place when a central bank is tightening monetary policy by raising interest rates. The rise in policy rates has the direct effect of lifting short-term bond yields. However, as policy tightens, the resulting downward revisions for future growth and inflation expectations can translate in to lower long-term bond yields, eventually prompting long rates to fall below short rates. An inverted yield curve acts as a disincentive to credit creation on the part of commercial banks, whose business models rely on borrowing short-term and lending long-term. Slower growth in lending, in turn, could warn of a downturn in the economy. With expectations of a slowing economy, investors are content to buy long-term bonds in anticipation that future economic weakness will prompt the central bank to ultimately cut rates. 

The issue has been of increasing interest to investors of late, given the marked flattening of the US yield curve in recent months. As the second chart shows, the gap between the 10-year and 2-year yields has narrowed to just 25 basis points as of mid-July – its lowest in nearly 11 years. During recent years, the flattening of the curve has coincided with the US Federal Reserve (the Fed) hiking interest rates as it has sought to unwind the extraordinary monetary stimulus put in place during the financial crisis.

The concern among some observers is that, with the Fed adopting a more hawkish tone of late - signalling two further 25bp rate hikes in 2018 and a further three rate hikes in 2019 - the curve could soon invert.

Could this time be different?

Some observers have cast doubt on whether a yield curve inversion would send a reliable recession signal this time around. There are several reasons why the yield curve’s predictive power might be diminished. Firstly, long-term rates might currently be artificially low compared with previous cycles as a result of central banks having bought large quantities of government bonds as part of their crisis-era quantitative easing (QE) programs.

Although the Fed is currently gradually winding down its balance sheet, it still holds over $2.3 trillion of US government bonds. Moreover, the European Central Bank’s QE programme is ongoing until the end of 2018 and the Bank of Japan’s policy of ‘yield curve control’ has the aim of keeping Japanese 10-year government bond yields close to zero. In a global bond market, ultra-low long-term yields in the euro zone and Japan act as an anchor for US rates.

Other factors could also be suppressing long-term bond yields during the current cycle. Globalisation and technological developments have contributed to a structural downshift in inflation expectations. In addition, against the backdrop of ageing populations, strong demand for fixed income securities from pension funds, who need to lock in income streams to match their liabilities, could also be bearing down on long-term yields.

There is also an argument that an inverted yield curve is only likely to herald a recession when real policy rates become overly tight. With core CPI inflation running at 2.3% in June and the Fed Funds policy rate at 1.75-2.0%, the real, inflation-adjusted rate is currently negative. Analysts at J.P. Morgan point out that none of the last eight US recessions started when the real Fed Funds rate was below 1.8%. If the Fed hikes rates to 3.0-3.25% in line with its median projection by the end of 2019, and core inflation comes in as the Fed forecasts at 2.1%, real rates would still be below levels traditionally associated with triggering a recession.

As well as the yield curve's message potentially being distorted, there is also the issue of timing. As the second chart shows, there is a considerable, and variable, lag between periods of yield curve inversion and the onset of recession. Moreover, J.P. Morgan reckon that during the last seven instances of the US yield curve inverting, the S&P500 equity index peaked on average ten months after the 10s-2s yield gap turned negative.

A sell signal?

What does all this mean for investors? For a start, it would be foolhardy to make investment decisions on the basis of just one indicator, and timing markets is almost impossible. The yield curve needs to be viewed within the context of broad economic and financial conditions. With the yield gap still positive and US corporate earnings growing solidly on the back of the Trump tax cuts, a wholesale exodus from the equity market would seem premature. However, recent developments in the yield curve are just another reminder that the business cycle is becoming increasingly mature.

Against the backdrop of escalating global trade tensions and less accommodative monetary policy, equity markets are unlikely to return to the high return/low volatility regime witnessed in 2017 anytime soon. Given the prospect of a less favourable risk-return environment, some de-risking of portfolios would appear appropriate.

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.